By Alan J. Andreini, Brencourt Advisors -- Ten years ago, a hedge fund’s stellar track record would overshadow investors’ worries about the fund’s everyday operations. Operational due diligence was a check the box function that took a few hours at most.

Those days are gone, partly because of the Madoff scandal and other more recent scams, but mostly because of the growing use of hedge funds in institutional portfolios. Today, all hedge fund managers who seek the large and stable institutional allocations must understand what it takes to assemble and operate an infrastructure that will pass examination under today’s new operational due diligence microscope. The game has changed.

What operational due diligence concerns have risen to the top of the list? I polled experts at leading asset-allocation advisory firms including, among others, Emily Lehrer, Head of Operational Due Diligence at Guggenheim Partners, Simon Fludgate, Principal Operational Due Diligence at Aksia and Mikael Johnson, Lead Partner – Alternative Investments at KPMG (who will also be panelists at a session I will be moderating at the upcoming GAIM USA conference in Boca Raton in January 2012.)

One issue on their due diligence checklist is understanding the quality and character of a hedge fund’s financing arrangements—in other words, what is the hedge fund’s counterparty risk exposure? That’s not surprising. After the collapse of Lehman Brothers in 2008 and now with current concerns about the Euro zone debt crisis, institutional investors want assurance that hedge funds are dealing with credit-worthy institutions.

Also near the top of the due diligence checklist is the hedge fund’s surveillance procedures to identify potential insider trading—also not surprising given the Galleon Group case and other recent insider trading scandals. They want to know how a firm’s restricted lists of securities—ones that neither the firm nor its individuals can trade because they have material non-public information are developed and monitored. Personal trading policies that deal with employees trading for their own accounts are being tightened at most firms, and institutional investors’ due diligence officers want to see those guidelines as well.

Since the 2008 credit crisis, governance has grown in importance with institutional investors, and that continues. According to the experts the spotlight is now on two governance areas. The first is narrowing the scope of hedge fund’s legal documents to give more rights to investors. The second is creating a board of truly independent and competent outside directors. Investors want assurance that these directors will take responsibility for seeing that the fund has the right procedures in place and that it is operating correctly.

New regulations have arrived at a time when expectations for the big returns of the past 30 years have dimmed. Due diligence officers also want assurance that a hedge fund manager can deal with the costs of complying with Dodd-Frank under this new normal, low-return environment. In short, they want to know the extent of a hedge fund’s business risk—does it have the working capital to cover every-day expenses?

Finally, operational due diligence experts realize that they cannot apply the same standards to new managers (with less than a two-year track record) or emerging managers (with less than with $150 million in assets under management) as they would to an established $20-billion AUM fund.

It is unrealistic, for instance, to expect a new manager to reduce his or her counterparty risk by using more than one prime broker. Similarly, young or small-AUM funds cannot afford to monitor their operations with the same level of sophistication as the multi-billion dollar funds. Furthermore, emerging managers often offer a discount on the typical 2-and-20 fee to early investors, which means they have even less cash flow with which to meet the new, high due diligence standards.

But because smaller, younger funds often outperform the bigger ones, some institutional investors are developing a modified due diligence formula for new and emerging managers. It is a work in progress.

This new, heightened role for operational due diligence is only a few years old. But these new standards are here to stay, and managers need to understand that.

Alan J. Andreini is Chairman of the Executive Committee at Brencourt Advisors, LLC in New York.

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